Tuesday, December 29, 2009

Markets Fail. That's Why We Need Markets.

This seemingly paradoxical view is based on several overlapping strands of research in economics as it pertains to development, history, technology, business expansion, and new-firm formation. According to this view, entrepreneurs at work in the economy – in finance, high tech, manufacturing, services, and beyond – are constantly experimenting, creating new business models, techniques, and technologies that upend the established order of things.

Some new technologies and innovations are genuine improvements and are long-lasting welfare enhancers. But others are the basketball equivalent of pump fakes – they look like the real deal and prompt market actors to leap hastily into action, only to realize later that their bets were wrong.

Given this dynamic, markets are unpredictable, prone to booms and busts, characterized by bouts of exuberance that are rational or irrational only in hindsight. But markets are also the only reliable mechanism for sorting out this messy process quickly. In spite of the booms and busts, markets drive genuine long-run innovation and wealth creation.

When innovation-driven excesses and imbalances are recognized in the marketplace, the system can correct itself quickly. This is less the case when government policy failure occurs. Because political failure is less publicly tolerable than market failure, the temptation becomes for policymakers to avoid acknowledging their role in creating or perpetuating problems. Or they double down on bad bets. So rather than recognize the government’s central role in the housing boom and bust and quickly changing its ways, we see the federal policy apparatus continuing to throw good money after bad in the mortgage market and on Wall Street.

Markets fail; but they learn from their failures. That’s why we need markets. Government can promise to guarantee our prosperity; but only markets can really deliver.

Related: In today's WSJ, Gregg Easterbrook reminds us that "capitalism is the only economic system in history that is rendered stronger by its own instability." In other words, markets fail; that's why we need markets.

Markets fail; but they learn from their failures. That’s why we need markets.

I don't think this is true. The history of financial crises is long and storied and each time the mistakes made are very similar. And yet, history keeps repeating itself and the mistakes keep being made. They keep being made because without proper regulation market forces push the market players to make the same mistakes over and over.

Chuck Prince, Citi's former CEO, was asked in July 2007, why did his firm continue to add exposure to the risky real estate market. His response:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.

Meaning if he did decide unilaterally to stop writing sub prime mortgages, his shareholders would question why is he losing market share in the "lucrative" sub prime mortgage field.

And yet, history keeps repeating itself and the mistakes keep being made. They keep being made because without proper regulation market forces push the market players to make the same mistakes over and over.

So, what we need is a bunch of really smart government types to figure it all out for us. Wrong.

"Market players" respond to opportunities. If the government in it's infinite stupidity creates distortions in the market that result in the potential for profit, "market players" will obviously exploit those opportunities for as long as they exist. In fact, they will lobby government to create distortions that they can exploit. These are called programs and regulations.

Blind faith in the government's ability to regulate competently and enforce those regulations fairly and efficiently often leads to crisis. Don't forget, Fannie and Freddie had their own regulator - one regulatory body to oversee two corporations - and they both failed. Bernie Madoff passed numerous regulatory investigations. Regulation is the lefts substitute for due diligence.

So, what we need is a bunch of really smart government types to figure it all out for us. Wrong.

First, I want to comment that its funny how you paint people as "government types". As if they are some sort of non-human, robot creatures that don't think properly. While, in fact, they probably went to the same schools and had the same educational experiences as people in the private industry.

Second, and more importantly, from 1945-1980 we basically held banks in more or less a straight jacket. Did we collapse as a country because of this?? Nope. In fact, our growth was stronger on average between 1945-1980 then it was between 1980-2009. In 1980, Reagan came in and so began the great era of deregulation. The effects were pretty much immediate. You had the Savings & Loan crisis in the 80s. You had the tech bubble in the late 90s. And now, you have this.

I am an evidence based thinker and ideology doesn't really appeal to me. So, the evidence is clear. We had 35 years of strong growth and no crises with strong regulation. And then we had 19 years with 3 crises, one being perhaps the biggest credit crisis in the history of mankind.

Capitalism is the greatest system ever created for alleviating general human misery, and yet it breeds ingratitude.

People ask, "Why is there poverty in the world?" It's a silly question. Poverty is the default human condition. It is the factory preset of this mortal coil. As individuals and as a species, we are born naked and penniless, bereft of skills or possessions. Likewise, in his civilizational infancy man was poor, in every sense. He lived in ignorance, filth, hunger and pain, and he died very young, either by violence or disease.

The interesting question isn't "Why is there poverty?" It's "Why is there wealth?" Or: "Why is there prosperity here but not there?"

At the end of the day, the first answer is capitalism, rightly understood. That is to say: free markets, private property, the spirit of entrepreneurialism and the conviction that the fruits of your labors are your own.

The problem for those of us who believe that capitalism offers the best chance we have for leading meaningful and worthwhile lives is that in this debate, the devil has always had the best tunes to play. Capitalism lacks romantic appeal. It does not set the pulse racing in the way that opposing ideologies like socialism, fascism, or environmentalism can. It does not stir the blood, for it identifies no dragons to slay. It offers no grand vision for the future, for in an open market system the future is shaped not by the imposition of utopian blueprints, but by billions of individuals pursuing their own preferences. Capitalism can justifiably boast that it is excellent at delivering the goods, but this fails to impress in countries like Australia that have come to take affluence for granted.

It is quite the opposite with socialism. Where capitalism delivers but cannot inspire, socialism inspires despite never having delivered. Socialism’s history is littered with repeated failures and with human misery on a massive scale, yet it still attracts smiles rather than curses from people who never had to live under it. Affluent young Australians who would never dream of patronising an Adolf Hitler bierkeller decked out in swastikas are nevertheless happy to hang out in the Lenin Bar at Sydney’s Circular Quay, sipping chilled vodka cocktails under hammer and sickle flags, indifferent to the twenty million victims of the Soviet regime. Chic westerners are still sporting Che Guevara t-shirts, forty years after the man’s death, and flocking to the cinema to see him on a motor bike, apparently oblivious to their handsome hero’s legacy of firing squads and labour camps.

Where capitalism delivers but cannot inspire, socialism inspires despite never having delivered. Socialism’s history is littered with repeated failures and with human misery on a massive scale, yet it still attracts smiles rather than curses from people who never had to live under it. Affluent young Australians who would never dream of patronising an Adolf Hitler bierkeller decked out in swastikas are nevertheless happy to hang out in the Lenin Bar at Sydney’s Circular Quay, sipping chilled vodka cocktails under hammer and sickle flags

These are all straw men arguments. I can do the same thing to capitalism. In fact, take the entire book Grapes of Wrath and I can use that as one giant straw man argument against capitalism.

So the anti-EMH (Efficient Market Hypothesis) argument for regulation must be based on the following: bankers are irrational and make lots of foolish loans. Regulators are rational and can see that these loans are too risky, and can protect bankers from hurting themselves. At a theoretical level this doesn’t even pass the laugh test. But what happened in practice? What position did the “regulators” take in this crisis? First we need to define “regulators,” who are much more than just the low-paid Federal bureaucrats that oversee the banking industry. Regulators are the watchmen, those who watch the watchmen, and those who watch those who watch the watchmen. In other words:

1. The President2. Congress3. The Fed4. The media5. Most academics6. Nouriel Roubini

Guess how many of these institutions warned us about the sub-prime crisis. Now guess how many were encouraging banks to behave even more recklessly than they did. Unless we plan on making Roubini dictator of the world, there is zero evidence from the sub-prime crisis that simply giving regulators more power would have helped. And how do we know that even Roubini wasn’t just lucky, and might miss the next fiasco?

The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.

GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.

Moreover, GLB didn't deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.

When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.

Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.

In reality the financial "deregulation" of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan's warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.

So the anti-EMH (Efficient Market Hypothesis) argument for regulation must be based on the following: bankers are irrational and make lots of foolish loans. Regulators are rational and can see that these loans are too risky

NO! The argument is bankers are part of a system that incentives them to be irrational. (See my quote from Chuck Prince above). Regulators do not have the same incentives.

Also, strict regulation works (See 1945-1980).

At a more broader level, think about the incentives we have when we come into this world. What is our main incentive? Well, like animals, our main incentive is to kill our rivals and take what is theirs. But "evil" governments have imposed social regulations on us such as: do not kill, do not steal.

How did these governments know that this "regulations" would work? How did they know they would be enforced properly? How did they know that these regulations were not just bailing out the weak at the expense of the strong?

Well, they thought about it. They looked at the evidence and determined that these were good regulations.

I strongly believe in markets. Last fall we had a collapse in confidence in financial markets. The inter-twining of the commercial banks and hedge fund markets became a precarious and murky giant market.

The hedge funds and commercial banks should be separate entitie and thus separate markets. The function of banks should be to take in deposits and lend. The hedge funds can financiallly engineer transactions and trade the residue.

When no evidence was ever presented to link GLB to the financial crisis -- and when former President Bill Clinton gave a spirited defense of this law, which he signed -- proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.

Pick up this book:

http://alturl.com/sccq

And read 300 pages about how CFMA and the repeal of Glass-Steagel contributed to this crisis. And by the way, Bill Clinton does not go without blame here.

And actually, speaking of evidence, there is no evidence that legislation like the CRA (which is commonly blamed by conservatives to cause the crisis) contributed at all to the crisis.

If you are a true capitalist then you have to support Glass-Steagel. Think about what Glass-Steagel does. The government right now insures a all of the retail deposits at banks. (It insures up to $250k explicitly and the rest implicitly).

So, without Glass-Steagel, banks are allowed to take advantage of the government guarantee and use the insured retail deposits to finance their risky hedge funds.

There are two solutions to this. You either repeal all implicit and explicit guarantees that governmetns dole out to bank deposits. This would return us to a 19th century financial world where bank runs were common and most people just kept their savings in a jar. Or, you put back into place Glass-Steagel.

If you do neither, you are endorsing the socialization of risk and the privatization of profits. That is the definition of CRONY CAPITALISM.

The efficent market idea relies on the idea of the perfect calculating machine human. There is no such human as behavioral economics shows us. Humans have emotions and behave as Chuck Prince said they do. In essence he was playing a larger version of keeping up with the Jones that motivates a lot of society. One way to help control this is to move back to the partnership model for companies that do proprietary trading, when you reach a level in the organization suddenly your entire net worth is at risk if the company screws up. This kept the old investment banks in check, because they partners were concerned to police the organizations for their own financial safety. Then ban proprietary trading for corporate entities. You could handle this while leaving some element by putting the proprietary trading desks into a partnership with the company being a limited partner, and the traders being the general partners. It is just a small legal trick to bring back accountablity to the trader, and remove the limited liablity shield for the trader.

A Plain Dealer review of more than 50 Afford-A-Home files found borrowers who, according to their applications, earned as little as $15,000 a year when the city -- and mortgage lenders -- gave them loans.

One woman, according to a letter in her file, was homeless and living in a car with her children when she got $10,000 from the city. Another couple received food stamps and were jobless when they got an Afford-A-Home loan.

Through 2004, the first-lien mortgages for Afford-A-Home buyers typically came from local banks fulfilling federal requirements to lend money in poorer neighborhoods. The loans carried low interest rates.

This story, banks making risky loans to fulfill federal requirements, was repeated over and over across the entire country. And please, don't bother with more of Ritholtz's garbage. The bankers hadn't suddenly lost their minds. The requirements weren't imaginary. The bankers were responding to pressure from regulators. Despite the crisis, the FDIC is still pressuring banks to make risky loans under the CRA:

Bad or delinquent loans? Zero. Foreclosures? None. Money set aside in 2008 for anticipated loan losses? Nothing. ... The bank even squeaked out a profit of $87,000. And its Tier 1 risk-based capital ratio was 31.6 percent, or more than three times higher than many community banks ...

Yet the FDIC has turned up the heat on the bank, giving it an apparently rare "needs to improve rating," for not making more risky loans under the Community Reinvestment Act:

There are no apparent financial or legal impediments that would limit the bank’s ability to help meet the credit needs of its assessment area. The FDIC examiners also faulted East Bridgewater "for not advertising and marketing its loan products enough. The bank, which does not have a Web site, offers fixed-rate mortgages.

Peter Wallison provides the simple truth that seems to escape people like Ritholtz. The government, by redefining and enforcing the CRA and by creating a market for risky loans, was responsible for the mortgage crisis:

Mortgage brokers had to be able to sell their mortgages to someone. They could only produce what those above them in the distribution chain wanted to buy. In other words, they could only respond to demand, not create it themselves. Who wanted these dicey loans? The data shows that the principal buyers were insured banks, government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and the FHA—all government agencies or private companies forced to comply with government mandates about mortgage lending. When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.

Machiavelli999, government believes it can micromanage something it doesn't understand. I have much more faith in Wall Street, which created and captured enormous real wealth in the global economy, and distributed that wealth to the masses.

The U.S. economy was better off in the 19th century before big government:

American Prosperity and Price Deflation Written by Richard M. Ebeling May 2008

The decades between 1865 and 1900 were the years of America’s industrial revolution. Before this time, America had an economy of primarily light industry and farming. By the beginning of the 20th century, however, the United States had surpassed all of the European nations in manufacturing, including Great Britain and Imperial Germany, the industrial giants of the time.

Mass immigration from Europe, huge capital investments, and technological improvements provided the means for America’s growth and rising standards of living that soon became the envy of the rest of the world.

During the years after 1865 prices in general slowly fell from their Civil War highs. A Consumer Price Index that stood at 100 in 1865 had declined to 57 by 1900, or a 43 percent decrease in prices over a 35 year period. On average prices went down around 1.2 percent each year over three and a half decades.

At the same time, indices of money wages in agricultural and manufacturing employment both rose during this period as labor was becoming more productive due to capital investments, even with a rising population resulting from millions of immigrants joining the American work force.

The index of money wages in agriculture rose by almost 40 percent between 1866 and 1900, while money wages in manufacturing went up 20 percent during this period. Thus, on average, money wages in general increased by about 30 percent for workers as a whole.

In combination with the productivity gains and the capital investments that resulted in the 43 percent decrease in the price level, this meant that in the last 35 years of the 19th century the real standard of living of the American people increased by almost 75 percent as measured by the positive change in the average American’s buying power in the market place.

Machiavelli999 said: "In fact, our growth was stronger on average between 1945-1980 then it was between 1980-2009."

The U.S. could afford poor economic policies after WWII, because the rest of the world's major economies were destroyed.

We had a stable period of prosperity in the '50s and '60s. However, in the '70s, we had the worst economic period since the Great Depression. There were four recessions, in a period of accelerating inflation, from 1970-82, including two severe recessions that were worse than the recent recession.

Also, in the '50s and '60s, the U.S. didn't have millions of uneducated Third World immigrants buying new houses, new autos, etc. However, we did have that phenomenon starting in the '80s.

I give credit to the Fed for improving monetary policy, since the Great Depression. At least the Fed, unlike Congress, knows it can't micromanage a large economy without undesirable effects.

Also, you stated "like animals, our main incentive is to kill our rivals and take what is theirs."

Humans are very fragile in nature. So, our main incentive is to cooperate with other humans to survive. That cooperation has developed into a most powerful machine: The corporation.

Junados, it depends upon whom you read the Bank for International Settlements does not regard the CRA as the source of the current problems. The BIS is headquatered in Switzerland and is the Central Bankers Central Bank. They should not have a US political axe to grind as any domestic contributor no doubt does.